The Bullish Case for Bitcoin (part 4 of 4)

Misconceptions, real risks and conclusion

Much of the prior parts of this series of articles focused on the monetary nature of Bitcoin. With this foundation we can now address some of the most commonly held misconceptions about Bitcoin.

Bitcoin is a bubble

Bitcoin, like all market based monetary goods, displays a monetary premium. The monetary premium is what gives rise to the common criticism that Bitcoin is a “bubble”. However,allmonetary goods display a monetary premium. Indeed, it is this premium (the excess over the use-demand price) that is the defining characteristic of all monies. In other words, money is always and everywhere a bubble. Paradoxically, a monetary good is both a bubble and may be undervalued if it’s in the early stages of its adoption for use as money.

Bitcoin is too volatile

Bitcoin’s price volatility is a function of its nascency. In the first few years of its existence Bitcoin behaved like a penny-stock and any large buyer — such as the Winklevoss twins — could cause a large spike in its price. As adoption and liquidity have increased over the years, Bitcoin’s volatility has decreased commensurately. When Bitcoin achieves the market capitalization of gold it will display a similar level of volatility. As Bitcoin surpasses the market capitalization of gold its volatility will decrease to a level that will make it suitable as a widely used medium of exchange. As previously noted, the monetization of Bitcoin occurs in a series of Gartner hype cycles. Volatility is lowest during the plateau phase of the hype cycle, while it is highest during the peak and crash phases of the cycle. Each hype cycle will have lower volatility than the previous ones because the liquidity of the market has increased.

Transaction fees are too high

A recent criticism of the Bitcoin network is that the increase in fees to transmit bitcoins makes it unsuitable as a payment system. However, the growth in fees is healthy and expected. Transaction fees are the cost required to pay bitcoin miners to secure the network by validating transactions. Miners can either be paid by transaction fees or by block rewards, which are an inflationary subsidy borne by current bitcoin owners.

Given Bitcoin’s fixed supply schedule — a monetary policy which makes it ideally suited as a store of value — block rewards will eventually decline to zero and the network must ultimately be secured with transaction fees.A network with “low” fees is a network with little security and prone to external censorship. Those touting the low fees of Bitcoin alternatives are unknowingly describing the weakness of these so-called alt-coins.

The specious root of the criticism of Bitcoin’s “high” transaction fees is the belief that Bitcoin should be a payment system first and a store of value later. As we have seen with the origins of money, this belief puts the cart before the horse. Only when Bitcoin has become a deeply established store of value will it become suitable as a medium of exchange. Further, once the opportunity cost of trading bitcoins is at a level at which it is suitable as a medium of exchange, most trades will not occur on the Bitcoin network itself but on “second layer” networks with much lower fees. Second layer networks, such as the Lightning network, provide the modern equivalent of the promissory notes that were used to transfer titles for gold in the 19th century. Promissory notes were used by banks because transferring the underlying bullion was far more costly than transferring the note which represented title to the gold. Unlike promissory notes, however, the Lightning network will allow the transfer of bitcoins at low cost while requiring little or no trust of third parties such as banks. The development of the Lightning network is a profoundly important technical innovation in Bitcoin’s history and its value will become apparent as it is developed and adopted in the coming years.

Competition

As an open source software protocol, it has always been possible to copy Bitcoin’s software and imitate its network. Over the years many imitators have been created, ranging from ersatz facsimiles, such as Litecoin, to complex variants like Ethereum which promise to allow arbitrarily complex contractual arrangements using a distributed computational system. A common investment criticism of Bitcoin is that it cannot maintain its value when competitors can be easily created that are able to incorporate the latest innovations and software features.

The fallacy in this argument is that the scores of Bitcoin competitors that have been created over the years lack the “network effect” of the first and dominant technology in the space. A network effect — the increased value of using Bitcoin simply because it is already the dominant network — is a feature in and of itself. For any technology that possesses a network effect, it is by far the most important feature.

The network effect for Bitcoin encompasses the liquidity of its market, the number of people who own it, the community of developers maintaining and improving upon its software and its brand awareness. Large investors, including nation states, will seek the most liquid market so that they can enter and exit the market quickly and without affecting its price. Developers will flock to the dominant development community which has the highest calibre talent, thereby reinforcing the strength of that community. And brand awareness is self-reinforcing as would-be competitors to Bitcoin are always mentioned in the context of Bitcoin itself.

A fork in the road

A trend that became popular in 2017 was to not only imitate Bitcoin’s software, but to copy the entire history of its past transactions (known as the blockchain). By copying Bitcoin’s blockchain up to a certain point and then splitting off into a new network, in a process known as “forking”, competitors to Bitcoin were able to solve the problem of distributing their token to a large user base.

The most significant fork of this kind occurred on August 1st, 2017 when a new network known as Bitcoin Cash (BCash) was created. An owner of N bitcoins before August 1st, 2017 would then own both N bitcoins and N BCash tokens. The small but vocal community of BCash proponents have tirelessly attempted to expropriate Bitcoin’s brand recognition, both through the naming of their new network and a campaign to convince neophytes in the Bitcoin market that Bcash is the “real” Bitcoin. These attempts have largely failed and is this is reflected in the market capitalizations of the two networks. However for new investors, there remains an apparent risk that a competitor might clone Bitcoin and its blockchain and succeed in overtaking it in market capitalization and thus become the de facto Bitcoin.

An important rule can be gleaned from the major forks that have happened to both the Bitcoin and Ethereum networks. The majority of the market capitalization will settle on the network that retains the highest calibre and most active developer community. For although Bitcoin can be viewed as a nascent money, it is also a computer network built on software that needs to be maintained and improved upon. Buying tokens on a network which has little or inexperienced developer support would be akin to buying a clone of Microsoft Windows that was not supported by Microsoft’s best developers. It is clear from the history of forks that have occurred in the last year that the best and most experienced computer scientists and cryptographers are committed to developing for the original Bitcoin and not any of the growing legion of imitators that have been created from it.

Real risks

Although the common criticisms of Bitcoin found in the media and economics profession are misplaced and based on a flawed understanding of money, there are real and significant risks to investing in Bitcoin. It would be prudent for a prospective Bitcoin investor to understand and weigh these risks before considering an investment in Bitcoin.

Protocol risk

The Bitcoin protocol and the cryptographic primitives that it is built upon could be found to have a design flaw, or could be made insecure with the development of quantum computing. If a flaw is found in the protocol, or some new means of computation makes possible the breaking of the cryptography underpinning Bitcoin, the faith in Bitcoin may be severely compromised. The protocol risk was highest in the early years of Bitcoin’s development when it was still unclear, even to seasoned cryptographers, that Satoshi Nakamoto had actually found a solution to the Byzantine General’s Problem. Concerns about serious flaws in the Bitcoin protocol have dissipated over the years but given its technological nature, protocol risk will always remain for Bitcoin, if only an outlier risk.

Exchange shutdowns

Being decentralized in design, Bitcoin has shown a remarkable degree of resilience in the face of numerous attempts of various governments to regulate it or shut it down. However the exchanges where bitcoins are traded for fiat currencies are highly centralized and susceptible to regulation and closure. Without these exchanges and the willingness of the banking system to do business with them, the process of monetization of Bitcoin will be severely stunted, if not halted completely. While there are alternative sources of liquidity for Bitcoin, such as over-the-counter brokers and decentralized markets for buying and selling Bitcoins likelocalbitcoins.com, the critical process of price discovery happens on the most liquid exchanges which are all centralized.

Mitigating the risk of exchange shutdowns is jurisdictional arbitrage. Binance, a prominent exchange that started in China, moved to Japan after the Chinese government halted its operations in China. National governments are also wary of smothering a nascent industry that may prove as consequential as the Internet, thereby ceding a tremendous competitive advantage to other nations.

Only with a coordinated global shutdown of Bitcoin exchanges will the process of monetization be halted completely. The race is on for Bitcoin to become so widely adopted that a complete shutdown becomes as politically infeasible as a complete shutdown of the Internet. The possibility of such a shutdown is still real, however, and must be factored into the risks of investing in Bitcoin. As was discussed in the prior section on the entrance of nation states, national governments are finally awaking to the threat that a non-sovereign, censorship resistant, digital currency poses to their monetary policies. It is an open question whether they will act on this threat before Bitcoin becomes so entrenched that political action against it proves ineffectual.

Fungibility

The open and transparent nature of the Bitcoin blockchain makes it possible for states to mark certain bitcoins as being “tainted” by their use in proscribed activities. Although Bitcoin’s censorship resistance at the protocol level allows these bitcoins to still be transmitted, if regulations were to appear that banned the use of such tainted bitcoins by exchanges or merchants, they could become largely worthless. Bitcoin would then lose one of the critical properties of a monetary good: fungibility.

To ameliorate the fungibility of Bitcoin, improvements will need to be made at the protocol level to improve the privacy of transactions. While there are new developments in this regard, pioneered in digital currencies such as Monero and Zcash, there are major technological tradeoffs to be made between the efficiency and complexity of Bitcoin and its privacy. It remains an open question whether privacy enhancing features can be added to Bitcoin in a way that doesn’t compromise its usefulness as money in other ways.

Conclusion

Bitcoin is an incipient money that is transitioning from the collectible stage of monetization to becoming a store of value. As a non-sovereign monetary good, it is possible that at some stage in the future Bitcoin becomes a global money much like gold during the classical gold standard of the 19th century. The adoption of Bitcoin as global money is precisely the bullish case for Bitcoin and was articulated by Satoshi Nakamoto as early as 2010 in anemail exchangewith Mike Hearn:

If you imagine it being used for some fraction of world commerce, then there’s only going to be 21 million coins for the whole world, so it would be worth much more per unit.

[I]magine that Bitcoin is successful and becomes the dominant payment system in use throughout the world. Then the total value of the currency should be equal to the total value of all the wealth in the world. Current estimates of total worldwide household wealth that I have found range from $100 trillion to $300 trillion. With 20 million coins, that gives each coin a value of about $10 million.

Even if Bitcoin were not to become a fully fledged global money and were simply to compete with gold as a non-sovereign store of value, it is currently massively undervalued. Mapping the market capitalization of the extant above-ground gold supply (approximately 8 trillion dollars) to a maximum Bitcoin supply of 21million coins gives a value of approximately $380,000 per bitcoin. As we have seen in prior sections, for the attributes that make a monetary good suitable as a store of value, Bitcoin is superior to gold along every axis except for established history. As time passes and the Lindy effect takes hold, established history will no longer be a competitive advantage for gold. Thus, it is not unreasonable to expect that Bitcoin will approach, and perhaps surpass, gold’s market capitalization in the next decade. A caveat to this thesis is that a large fraction of gold’s capitalization comes from central banks holding it as a store of value. For Bitcoin to achieve or surpass gold’s capitalization, some participation by nation states will be necessary. Whether the Western Democracies will participate in the ownership of Bitcoin is unclear. It is more likely, and unfortunate, that tin-pot dictatorships and kleptocracies will be the first nations to enter the Bitcoin market.

If no nation states participate in the Bitcoin market, there still remains a bullish case for Bitcoin. As a non-sovereign store of value used only by retail and institutional investors, Bitcoin is still early in its adoption curve — the so-called “early majority” are now entering the market while the late majority and laggards are still years away from entering. With broader participation from retail and especially institutional investors a price level between $100,000 and $200,000 is feasible.

Owning bitcoins is one of the few asymmetric bets that people across the entire world can participate in. Much like a call option, an investor’s downside is limited to 1x while their potential upside is still 100x or more. Bitcoin is the first truly global bubble whose size and scope is limited only by the desire of the world’s citizenry to protect their savings from the vagaries of government economic mismanagement. Indeed, Bitcoin rose like a Phoenix from the ashes of the 2008 global financial catastrophe — a catastrophe that was precipitated by the policies of central banks like the Federal Reserve.

Beyond the financial case for Bitcoin, its rise as a non sovereign store of value will have profound geopolitical consequences. A global, non-inflationary, reserve currency will force nation states to alter their primary funding mechanism from inflation to direct taxation, which is far less politically palatable. States will shrink in size commensurate to the political pain of transitioning to taxation as their exclusive means of funding. Furthermore, global trade will be settled in a manner that satisfies Charles de Gaulle’s aspiration that no nation should have privilege over any other:

We consider it necessary that international trade be established, as it was the case, before the great misfortunes of the World, on an indisputable monetary base, and one that does not bear the mark of any particular country.

50 years from now, that monetary base will be Bitcoin.

Acknowledgements

I want to thank Alex Morcos, John Pfeffer, Pierre Rochard, Mat Balez, Ray Boyapati, Daniel Coleman, Patri Friedman, Ardian Tola and Michael Flaxman for their valuable feedback on earlier drafts of this series of articles. Sanjay Mavinkurve generously provided his brilliant design skills to create some of the charts in earlier parts of this series.